Saturday, June 13, 2009

Analysing the sub-prime crisis

One of the most comprehensive analysis of the global macroeconomic paradigm that caused the ongoing economic crisis is by the Brazlian economist André Lara Resende (thanks to Niranjan for sending it). While predicting a long drawn out and slow recovery during which the excessive debt is worked out, he makes several interesting points

1. The dominant macroeconomic consuensus of the past few decades has been that emerging economies had to follow restrictive fiscal and monetary policies when faced with currency and and other crisis. When faced with a halt in capital inflows, run on the currency, stagnant economic growth, and the rise of unemployment, macroeconomic policy had necessarily to be geared towards confidence (among external investors) rebuilding. Andre writes, "in case of crisis, economic policy could not be anti-cyclical, in order to attenuate its impact (reduce its social costs); it had to be perversely pro-cyclical, to rebuild confidence".

2. Over the past three decades, buoyed by the confidence of having conquered the business cycle, the specter of inflation, and overcome the limits and any binding constraints to economic growth, the first world economies emerged as issuers of reserve-currencies. This enabled them to have the capacity to finance the massive external deficits.

3. Emerging economies have relied on exports to drive economic growth and sidelined domestic consumption, and saw this as their path to integration with the world economy. They have followed excessively conservative monetary policy as "an insurance against the stubborn insecurity of (foreign) investors". This has in turn prevented domestic consumption from becoming an engine of growth and deprived businesses off access to cheaper capital. Further, to avoid "disrputive currency devaluations", these economies were also forced into accumulating massive foreign exchange reserves.

4. The high rates of growth in developed economies, based on the increase in consumption "cannot be sustained for a prolonged period, especially since they have low or no demographic growth, an inverted demographic pyramid and an already very high standard of living. The maintenance of a high rate of consumption growth depends, both on the creation of new consumption needs and on the permanent expansion of credit to families with ever higher levels of debt. The rich central countries consume, financed by ever higher levels of debt, in order to satisfy ever more artificial needs, with products made in China, which controls its labor costs and buys raw materials from emerging countries."

5. The current crisis has its origins in both deficiencies of the regulatory framework and the global macroeconomic imbalances, both complementing each other. "The macroeconomic imbalance would not have been so deep and persistent without the extraordinary development of the financial market. Indebtedness and leverage would not have reached such extremes in the world without the international macroeconomic imbalance." He cautions against an emotionally impulsive effort at regulation that is "geared to avoid errors of the past and not necessarily able to cope with the challenges of the future".

5. The driving goal of Central Banks in the aftermath of the sub-prime bubble bursting was to avoid the mistakes of the Great Depression, by flooding the system with liquidity at any cost and thereby stem the "deterioration of the value of assets". However, as Resende writes, "The speed of the deterioration of the value of assets in bank portfolios remained higher than the capacity of government agencies to provide them capital through public funds and simultaneously absorb their troubled assets... As long as the non-financial private sector has excessive debt and remains willing to save in order to reduce its indebtedness, the only likely borrowers are precisely those who are unable to repay their debts. Only those who cannot honor their previous commitments will be willing to take additional loans to roll over their debt. The reduction of the leverage exclusively in the financial sector is not sufficient to restore the normal activity of the financial system... Firms and households have to reduce their over indebtness before the system can function again." In other words, as long as excessive debt is not digested, both monetary and fiscal policies are likely to be ineffective.

6. The major difference between 1929 and now is the level of indebtedness in the economy. Then the generalized bankruptcy of banks and firms solved the problem of excessive indebtedness, and the economy was facing "thorough disorganization and massive unemployment". Further, there was a "lack of demand because there was no economic activity and no income". Today, households and firms are faced with the brunt of excessive debt, forcing them to reduce expenditures and increase savings, and the "lack of demand is the result of the exceptionally high rate of savings required to bring back private debt to reasonable levels" (and not lack of income), much like Japan in the nineties. As Irving Fisher argued, the "virtuous circle of the Keynesian expenditure multiplier" is broken as the "income generated by the increase in public spending is saved by the private sector in order to diminish its debt".

7. He sees "chronic inflation as essentially a question of excessive debt of the public sector, and deflation as a question of excessive debt of the private sector... The end of great inflations requires necessarily the reduction of public debt, either through the socially costly hyperinflation or, instead, through some form of default... The option not to throw public resources to rescue an insolvent private sector in a deflationary situation is the symmetric equivalent of letting the economy slide into open hyperinflation in a chronic inflation environment."

8. He feels that a supra-national world reserve currency, issued by a truly credible supra-national issuer, is the only sustainable solution to "reverse the asymmetry behind the large macroeconomic imbalances of the last decades". As events in the aftermath of the crisis - deleveraging and the appreciation of dollar - has shown, the dollar reigns as the most credible reserve currency for the time. But the massive US deficits and persistently high imbalance in its external account, coupled with the possibility of both inflation and devaluation of dollar (both in the interest of the US, if achieved in a controlled manner), raises major concerns among its creditors, chiefly the Central Banks of emerging economies. It is now widely acknowledged that dollar has managed to stay afloat despite the massive current account deficits only by "the force of habit and the lack of alternatives". This also raises the moral hazard for policy makers in the US to continue with their present policies without being forced into remedying the structural imbalances in the economy.

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Though Resende's analysis is brilliant and comprehensive, I cannot but get the feeling that it may be skewed towards the most extreme assumptions on the pessimistic side. For example, Resende feels that the unconventional monetary policy responses, aimed at recapitalizing banks and making them willing to lend, will fail because the crisis has crowded out all the credit-worthy borrowers. He also discounts for any such borrowers in the financial sector. I have two issues with this line of arguement.

One, it should not be forgotten that the private sector debt burdens have been amplified many times more than the actual leverage by the precipitous fall in asset (both housing and financial instruments) values. This burden can be eased if confidence returns to atleast some parts of the financial markets and asset values rally back. Now this is not as improbable as it appears, especially with the financial markets (witness the dramatic recovery in financial markets in the emerging economies).

Second, there are still many formidable credit-worthy borrowers in the financial sector. Many of the hedge funds and private equity firms have remained relatively less affected. The numerous bankruptcies, failures and mergers have left the remaining "too-big-to-fail" institutions, which survived the crisis, in an impregnable position, with considerable bargaining power and resources to draw upon. These institutions also have the advantage of piggybacking on the huge credit expansion indulged in by governments desperate to do anything to stem the decline in the financial markets. Further, there are already signs of green shoots in many emerging economies, which opens up the possibility of many profitable investments avenues in these markets. All of these could contribute substantially towards restoring confidence in the markets and upward spiralling effect on asset values, which in turn could substantially ease the debt burdens.

Again, Resende may be taking an extreme position in assuming that all the Keynesian stimulus will end up getting saved and that all of private sector is insolvent. Fisher is right that fiscal and monetary policies does not yield the desired results when excessive debt and deflation prevails. But that is different from assuming that it does not yield any result, and this takes us back to the debate about what types of fiscal spending are more effective when the economy is faced with a deep recession. And, while it is true that Wall Street and US consumers are excessively leveraged, the same cannot be said for the US corporates. Their handicap is not debt-ridden and bankrupt balance sheets, but a credit squeeze in the financial markets and weak domestic and external demand. The dramatic credit expansion policies are aimed at least partially de-clogging these markets. The sources of revival in demand is threefold - putting money in the hands of those consumers who are likely to spend, government itself becoming the consumer of last resort by generating demand in sectors like infrastructure, and external demand looking up and driving exports. While the extent of impact of each of these debatable, there are undoubtedly enough possibilities that can tip the outcome of fiscal stimulus spending demand either way.

Also, the doomsday predictions in a deflation environment may be misplaced. After all, just a decade back, Japan experienced the same and though it experienced a decade long slow recovery, it emerged out relatively fine, despite a few important policy mistakes (raising taxes in late nineties thereby nipping the green shoots of recovery in the bud, and being slow in addressing the bad debt problem).

In both these examples, the final outcome depends on a whole lot of unforeseen and emergent circumstances. The challenge is to prevent a steep downward spiral leading to a complete economic collapse (deflation, stagnation and unemployment, bankruptcies and debt defaults, ballooning deficits, and hyper-inflation) and hope that with time things will return to normal. In any case, the most optimistic forecast would have to be for a long drawn out recovery, primarily triggered off by confidence slowly returning to the financial markets and generating a rally in asset prices.